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July 16, 2012

What Could Boost Residential REITs?

Situations vary by region, but there are some signs that pressure on rents could be building

(Photo: AP)

Despite the slow improvement of home prices, apartment rents continue to increase.

The average Manhattan apartment rented for more than $3,400 this spring, an increase of 3% from last year and an all-time high, according to a report at MarketWatch.com.

Rents in large West Coast cities have been increasing rapidly, too. Real estate research firm Reis Inc., says that rents in the San Francisco area were up 5.9% in the spring from the previous year and were the fastest-rising rents in the U.S.

REITs investing in residential apartments have benefitted from the tighter rental market. As total-return data from the National Association of Real Estate Investment Trusts (NAREIT) shows, REITs investing in residential apartments have turned in strong short-, mid- and long-term performances during the past decade.

Table: FTSE NAREIT U.S. Real Estate Index Returns REITs

Compound Annual Total Returns (%)

Dividend Yield %

Year-to-date*

1-Year

3-Year

5-Year

10-Year

Residential Apartments

2.82

10.82

10.44

40.98

7.33

12.56

FTSE NAREIT All Equity REITS

3.25

16.11

12.48

32.40

2.60

10.32

*Through month-end June 2012. Data provided by NAREIT.

Calvin Schnure, vice-president, research and industry information with NAREIT, cites the slow economy as a driver of recent demand for apartments. “What happened with the apartment REITs over the past two years was they were really benefiting as housing demand shifted from single family into renter because of the housing crisis,” he says.

“People who either lost their homes and needed to rent, or might have considered buying but now they weren’t so sure because housing prices were weak or falling, or maybe they just couldn’t qualify for a mortgage—they went into apartments,” Schnure explains.

At the peak of the housing construction boom in 2006 builders supplied roughly an extra 2 million housing units more than what the population needed, he says—it was a speculative boom.

That condition of excess supply has changed, though, and since then, construction has been running well below the trend pace. Schnure maintains the pace of building isn’t just below the boom’s pace—it’s below what’s needed to keep up with population growth.

“A lot of things slowed in the economic crisis but one thing that did not slow was population growth,” says Schnure. “So, the people who were 17 years old at the beginning of the crisis are 22 now and they’re signing a lease right now or they want to sign a lease right now. This population growth is putting increasing burdens on our housing stock and we have not been building new housing. When you see these stories that the rental rates are starting to firm in a lot of cities, that means we’re starting to see the signs that these markets are beginning to tighten.”

The data support Schnure’s case. He points to at least 3 million and possibly as many as 4 million or 5 million “shadow households.” This group includes potential renters who have doubled up with roommates or are living with parents, for example.

When these persons start actively seeking rentals, they’ll drive demand higher but they’ll face a tighter supply in many markets due to a drop-off in apartment construction.

“In a strong year apartment construction is about 300,000 a year,” says Schnure. “Working at a shortfall of 3 million rental units once the job market gets back on its feet, it’s going to take 10 years to construct enough rental units to house the pent-up demand, the doubled-up population that’s accumulated over the past couple of years. This is on a national figure of course--I’m not talking about specific markets.” There may be some metro areas and some neighborhood where a few new apartment buildings open up, and that alleviate could the pressure on rents, he notes.

“But overall the magnitude of the pent-up demand, the doubled-up households and the people who are sharing living quarters is much greater than the construction even in the strongest year,” the NAREIT executive notes.

What’s his advice for investors who have watched apartment REITs move higher over the past two years and wonder whether they’re fully priced?

“We’re actually facing a situation where what these apartment REITs own, existing apartment buildings, are going to be in increasing demand, which actually sets the stage for continued strong gains,” Schnure concludes.